New Weapons for the ECB

Continued reliance on European Central Bank President Mario Draghi’s weapons will probably succeed in keeping quasi-insolvent states and banks afloat. But it will do so only at the expense of deeper stagnation and uglier political tensions.

ATHENS – During his tenure as President of the European Central Bank, Mario Draghi forged a variety of weapons that he deployed to shield the eurozone from menacing deflationary forces. Without them, the euro would have been history. However, the deflationary specter haunting Europe was never truly defeated and is now back with considerable vengeance.

In the dying days of his presidency, Draghi is throwing everything he has at the problem, in the hope of buying time for Europe’s governments and for his successor, Christine Lagarde. But, like antibiotics to which bacteria have fully adapted, his weapons no longer work. On the contrary, they inflict considerable damage on savers in Europe’s heartland, who blame the ECB for the resulting negative interest rates that eat into their savings, and encourage no appreciable productive investment in the green technologies and infrastructure that Europe so desperately needs.

In his penultimate press conference as ECB president, Draghi warned that very little is left in the ECB’s arsenal that could do the job. For that reason, he urged politicians to boost aggregate demand via higher public spending and a substantial relaxation of the EU’s absurd commitment to procyclical fiscal policies, which he rightly fears will magnify the coming recession.

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Why didn't Europe's governments coordinate a sensible fiscal policy? The answer is that some countries- like Greece- weren't sensible at all. You can't coordinate anything with a crazy person. Furthermore, other some other countries were politically dysfunctional- there was deep popular anger at nepotistic elites- and thus followed a path of technocratic least resistance or 'kicking the can down the road'.

Europe failed to anticipate that labour would be more mobile than capital and that the new 'knowledge based' industries would have different types of scale and scope economies. Furthermore, some countries misallocated resources towards construction which caused significant structural unemployment and capacity underutilization. In other cases there was reluctance to do large scale infrastructure renewal because of increased compliance costs and reduced Public Sector administrative capacity. Speaking generally, 'Green' panaceas were touted by people who should have known better. Thus, Government spending could have a negative multiplier effect quite independent of any 'crowding out'. This is why fiscal policy was ineffective.

It is by no means a settled matter that Lagarde will be a roi faineant. France has a different political culture and probably can spearhead infrastructure and defense projects with a positive return.

Under a new administration, Greece may yet turn the corner like Portugal while, sooner or later, the Italians too will find a way forward. There is no reason to believe that the EU is bound to repeat its past mistakes. The rise of China has concentrated minds. European countries are now more ready to reduce administrative hurdles and other compliance costs while increasing the efficiency of big Investment projects thanks to learning effects and second mover advantage.

The ECB does need reform, but not a 'new weapon' that will blow up in its face. The first requisite is that the meaning of 'price stability' is clarified, in accordance with economic theory and practice, such that its inherent multiple realizability allows the pursuit of efficiency. This will be much easier now thanks to Draghi's spadework.

Moral hazard can be directly tackled by better screening- i.e regulation. This is scarcely controversial. The crisis has long passed and there is no contagion risk from a judicial approach.

'Copper bottomed safe assets' don't exist. However, as a matter of convention, there is a sufficiency of candidates within the zone and thus this is merely a question of leadership and coordination. There is no reason to believe that Europe will continue to cut off its own nose in the context of a rising China and a more distant U.S.

In the Eurozone treaties no distinction is made between Maastricht compliant and non compliant debt. The rule is against any 'monetary financing' by the ECB. To bring the thing in by the back door, apart from being illegal, is to restore two different types of moral hazard. The first is that GNP will be overstated and the second is that naughty countries will use any ECB windfall to distort secondary markets- in other words, fraud will once again be the way to go.

Varoufakis says ' if a member state’s debt-to-GDP ratio is 90%, the ECB conversion bond services €667 of each €1,000 of maturing state debt. The less the member state has exceeded its Maastricht debt limit, the larger the percentage of its public debt that will be serviced at the ultra-low ECB bond yields.' So, first the Govt. artificially boosts its GDP to get more 'free money' and then it uses it to monkey around in secondary markets. No doubt, plenty of apparatchiks get rich in the process but the bubble soon bursts. The ECB is now in the 'monetary financing' business in defiance of Eurozone treaties and so Europe goes to the dogs. Varoufakis, with his usual wit, describes the bonds the ECB now holds as 'safe assets'! No doubt 'green bonds' too are very safe. Indeed, they grow on trees!

Varoufakis does not understand what was at the root of Greek's problems- viz. telling lies about GDP and monkeying around in secondary markets. He remains convinced that the real story is about Nazi 'banks rather than tanks' which suddenly appeared in the streets of Athens to impose the rule of some 'Troika' of evildoers. Hopefully, now Greece has a new Government, it will begin to reclaim its natural place as a Knowledge and Trade Hub for a very vibrant and dynamic region of the world.

Another unreasonable country is Germany, which has exported unemployment via its Hartz reforms and refuses any progress on fiscal federalism necessary to balance the trade deficit and trade surplus nations within the Euro zone.

Vivek, your comment is too vague for a lay person to understand. You seem to be in favor of the status quo tools for maintaining and fixing Europe, while at the same time speak of the entrance of China as a factor in future growth without acknowledging that this single thing brings more possible good news to Europe than anything else you or Yanis have mentioned.

In other words, China’s Belt and Road is a big deal. You also mention Portugal as a good role model, but fail to mention that Portugal has a quasi socialist government.

New productive growth from doing business with China and better social welfare policies by adopting socialist safety nets are more certain to lift Europe than any monetary tricks from Draghi’s ECB, yet you seem to approve of using the central bank as if it were actually government.

Your other points don’t seem to amount to anything that we readers can be clear about. At least this is my take. I could be wrong and it is me that is deficient. I don’t mean to criticize in an unfriendly way.

The original 'ordo-liberal' 'growth and stability' pact had 2 features1) Fiscal discipline- i.e. Govts. would pursue sensible policies and keep truthful accounts- which in turn would mean lower inflation and real interest rates. The idea was if each country is honest and does smart things then the whole Eurozone will be stable and attractive to investors.2) Establishment of a 'Social minimum'- i.e. everybody would be guaranteed to a safety net re. income, health care, education, housing etc. Greece did not play by the rules. Also it refused to reform its benefits system- so some had no protection while those with powerful unions or political influence were 'feather bedded'. Many of these people had to take a big haircut- so the fraud and waste was at their expense.

The Greeks thought they could get a better deal because of 'contagion risk'- i.e. if they defaulted this could cause a lot of European banks to collapse- and initially this worked when they threatened a referendum. However, the rest of the PIGS reformed- Portugal is a shining example of a country which pursues sensible policies, for e.g. on drugs, and, yes, this is genuine Socialism not playacting- but this meant that Greece, which was turning the corner, could no longer play that card. Yet it did so anyway and paid a high price. Now there is a different Govt. It needs to work with the Unions and create trust. Then it will prosper because the people are honest and enterprising.

China is still quite a poor country. It is capable of sudden policy changes of great magnitude. Thus one can't put all one's eggs in that basket. Still, as you say, Europe benefits from becoming integrated into 'Eurasia'. However, it must have pragmatic policies. It can no longer afford to moralize and lecture the world.

I don't think Central Banks have any competence save with reference to inflation and overseeing the Banking system. History will judge Draghi favorably because he won important legal cases which were wrong-headed and could have hurt Europe even more. I think a strong ECB head could, because of the dysfunctional nature of European politics at this moment, help kickstart vital infrastructure projects which are continental in scope. But all countries must implement a basic social minimum and act responsibly in terms of migration flows. However, there is a case for migrants being required to pay a portion of their tax back to their country of origin. Japan has a system of 'gifts' by which the migrant worker sends money back to his natal place.

My main point in my previous comment was that Varoufakis's proposal is illegal and will recreate the same problem which has already cost Greece terrible suffering. I apologize if my language was vague or difficult to understand.

Thank you Vivek, your reply is really excellent. One thing to mention that adds context to our discussion is that the ordo-liberal standards of Europe are considered communism in the United States. Since America bullies the world to comply with its neo-liberal, laissez-faire capitalist goals, anything we say about political economy has to be understood in this light. As long as the U.S. is able to force the world to its knees, no country is free to pursue its own best interest. Corruption will continue, and power will consolidate.

America's lopsided balance of payments creates a situation here (the US) where there is a constant inflow of money, fueling speculation, and one result is our twin deficits and loss of productive incomes. I'm sure this chaotic mess in America adversely affects Europe and the rest of the world, but I don't have the ability to make it relevant to this discussion, so I'll stop here. Yanis' book the Global Minotaur deals with this problem beautifully. There is another writer who deals with the subject that I recommend, Michael Pettis. He is less political than Yanis, but brings good ideas to the discussion.

Question for you: how would Yanis' proposal bring Greece suffering? Is it possible to separate your complaints about Greece's national accounting from Yanis' proposal? It could be that the ordo-liberal standards of Europe are incompatible with the oligarchic control and corruption in Greece, and this has to be dealt with first. For that matter, the U.S. should be held to the same high standards, being that we live in a very controlled environment over here where the only consistent fact of life is that every aspect of our lives has a price.

To go one step deeper, I am very much a fan of the economist Richard A. Werner and the sovereign money movement. The entire global economy is a construct not of needs and wants of people, but of rent seekers. Our money supply is created mostly from bank lending. The "loanable funds theory" is a flesh eating zombie. So much of the world's problems owe their roots to this rent seeking monster. One of the best speakers on the potential of money to do good is the economist Bernard Lietaer.

Thanks again for writing your response. I will look for your writing wherever I can find it.

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